Many businesses will pay less federal income taxes in 2018 and beyond, thanks to the Tax Cuts and Jobs Act (TCJA). And some will spend their tax savings on merging with or acquiring another business. Before you jump on the M&A bandwagon, it's important to understand how your transaction will be taxed under current tax law.
3 Favorable TCJA Changes for Businesses
The Tax Cuts and Jobs Act (TCJA) contains several provisions that will lower federal income taxes for businesses. Here's an overview of three pro-business changes.
1. Tax Rate Changes
The TCJA permanently reduced the corporate federal income tax rate to a flat 21% for tax years beginning after 2017.
For 2018 through 2025, the TCJA also lowered the individual federal income tax rates on income from pass-through business entities. These include sole proprietorships, limited liability companies (LLCs), partnerships and S corporations. For those years, the maximum individual federal rate is 37%. However, the 3.8% net investment income tax (NIIT) may also apply to passive business income recognized by individual taxpayers.
Important: The federal income tax rates are unchanged for long-term capital gains recognized by individuals. The maximum rate is 20%, but the 3.8% NIIT may also apply.
2. New Deduction for Income from Pass-Through Business Entities
For tax years beginning in 2018 through 2025, the qualified business income (QBI) deduction is potentially available to individual pass-through entity owners. The deduction can be up to 20% of an owner's share of passed-through QBI. This break expires at the end of 2025, unless Congress extends it.
Numerous rules and restrictions apply to the QBI deduction. For example, above certain income levels, the deduction may be limited or eliminated for service businesses and businesses that haven't paid enough in W-2 wages or invested enough in fixed assets. Contact your tax pro to determine whether you qualify for this tax break.
3. Expanded First-Year Depreciation Breaks
The TCJA allows 100% first-year bonus depreciation for qualifying property placed in service between September 28, 2017, and December 31, 2022. The bonus depreciation percentages are scheduled to gradually phase out as follows:
Bonus depreciation is scheduled to expire at the end of 2026, unless Congress extends it.
Important: For certain property with longer production periods and aircraft, the bonus depreciation cutbacks are delayed by one year. For example, the 100% bonus depreciation rate applies to such property that's placed in service before the end of 2023, and the 20% rate applies to property that's placed in service in calendar year 2027.
In addition, the TCJA permanently increases the maximum Section 179 deduction to $1 million for qualifying property placed in service in tax years beginning in 2018. That amount will be adjusted annually for inflation.
The Sec. 179 deduction phaseout threshold has also been permanently increased to $2.5 million, with annual inflation adjustments.
For tax years beginning in 2019, the maximum deduction is $1.02 million, and the phaseout threshold is $2.55 million.As under prior law, Sec. 179 deductions can be claimed for qualifying real property expenditures, up to the maximum annual allowance. There's no separate limit for real property expenditures, so Sec. 179 deductions claimed for real property reduce the maximum annual allowance dollar for dollar.
Stock vs. Asset Purchase
From a tax perspective, a deal can be structured in two basic ways:
1. Stock (or ownership interest) purchase. A buyer can directly purchase the seller's ownership interest if the target business is operated as a C or S corporation, a partnership, or a limited liability company (LLC) that's treated as a partnership for tax purposes. This is commonly referred to as a "stock sale," although some sales may involve partner or member units.
The now-permanent flat 21% corporate federal income tax rate under the TCJA makes buying the stock of a C corporation somewhat more attractive for two reasons. First, the corporation will pay less tax and, therefore, generate more after-tax income. Second, any built-in gains from appreciated corporate assets will be taxed at a lower rate when they're eventually sold. These considerations may justify a higher purchase price if the deal is structured as a stock purchase.
In theory, the TCJA's reduced individual federal tax rates may also justify higher purchase prices for ownership interests in S corporations, partnerships and LLCs treated as partnerships for tax purposes. Why? The passed-through income from these entities also will be taxed at lower rates on the buyer's personal tax returns. However, the TCJA's individual rate cuts are scheduled to expire at the end of 2025, and they could be eliminated even earlier, depending on future changes enacted by Congress.
2. Asset purchase. A buyer can also purchase the assets of the business. This may be the case if the buyer cherry-picks specific assets or product lines. And it's the only option if the target business is a sole proprietorship or a single-member LLC (SMLLC) that's treated as a sole proprietorship for tax purposes.
Under federal income tax rules, the existence of a sole proprietorship or an SMLLC treated as a sole proprietorship is ignored. Rather, the seller, as an individual taxpayer, is considered to directly own all the business assets. So, there's no ownership interest to buy.
Important: In certain circumstances, a corporate stock purchase can be treated as an asset purchase by making a Section 338 election. Ask your tax advisor for details.
Business buyers and sellers typically have differing financial and tax objectives. While the TCJA doesn't change these basic objectives, it may change how best to achieve them.
Buyers typically prefer asset purchases. A buyer's main objective is usually to generate sufficient cash flow from the newly acquired business to service any acquisition-related debt and provide an acceptable return on the investment. Therefore, buyers are concerned about limiting exposure to undisclosed and unknown liabilities and minimizing taxes after the deal closes.
For legal reasons, buyers usually prefer to purchase business assets rather than ownership interests. A straight asset purchase transaction generally protects a buyer from exposure to undisclosed, unknown and contingent liabilities.
In contrast, when an acquisition is structured as the purchase of an ownership interest, the business-related liabilities generally transfer to the buyer — even if they were unknown at closing.
Buyers also typically prefer asset purchases for tax reasons. That's because a buyer can step up (increase) the tax basis of purchased assets to reflect the purchase price.
Stepped-up basis lowers taxable gains when certain assets, such as receivables and inventory, are sold or converted into cash. It also increases depreciation and amortization deductions for qualifying assets. Expanded first-year depreciation deductions under the TCJA make asset purchases even more attractive, possibly warranting higher prices if the deal is structured that way. (See "3 Favorable TCJA Changes for Businesses" at right.)
In contrast, when corporate stock is purchased, the tax basis of the corporation's assets generally can't be stepped up unless the transaction is treated as an asset purchase by making a Sec. 338 election.
Important: When an ownership interest in a partnership or LLC treated as a partnership for tax purposes is purchased, the buyer may be able to step up the basis of his or her share of the assets. Consult your tax advisor for details.
Sellers generally prefer stock sales. On the other side of the negotiating table, a seller has two main nontax objectives:
- Safeguarding against business-related liabilities after the sale, and
- Collecting the full amount of the sales price if the seller provides financing.
A seller may provide financing through an installment sale or an earnout provision (where a portion of the purchase price is paid over time or paid only if the business achieves specific financial benchmarks in the future).
Of course, the seller's other main objective is minimizing the tax hit from the sale. That can usually be achieved by selling his or her ownership interest in the business (corporate stock or partnership or LLC interest) as opposed to selling the business assets.
With a sale of stock or other ownership interest, liabilities generally transfer to the buyer and any gain on sale is generally treated as lower-taxed long-term capital gain (assuming the ownership interest has been held for more than one year).
Important: Some, or all, of the gain from selling a partnership interest (including an interest in an LLC treated as a partnership for tax purposes) may be treated as higher-taxed ordinary income. Consult your tax advisor for details.
When negotiating a sale, the buyer and seller need to give and take, depending on their top priorities. For example, a buyer may want to structure the deal as an asset purchase. Agreeing on a higher purchase price, combined with an earnout provision, may convince the seller to agree to an asset sale, which comes with a higher tax bill than a stock sale.
Alternatively, a seller might insist on a stock sale that would result in lower-taxed long-term capital gain. In exchange, the buyer might agree to pay a lower purchase price to partially compensate for the inability to step up the basis of the corporation's assets. And the seller might agree to indemnify the buyer against certain specified contingent liabilities (such as underpaid corporate income taxes in tax years that could still be audited by the IRS).
Purchase Price Allocations
Another bargaining chip in asset purchase deals — including corporate stock sales that are treated as asset sales under a Sec. 338 election — is how the purchase price is allocated to specific assets. The amount allocated to each asset becomes the buyer's initial tax basis in the asset for depreciation or amortization purposes. It also serves as the sales price for the seller's taxable gain or loss on each asset.
In general, buyers generally want to allocate more of the purchase price to:
- Assets that will generate higher-taxed ordinary income when converted into cash, such as purchased receivables and inventory, and
- Assets that can be depreciated in the first year under the expanded bonus depreciation and Sec. 179 deduction breaks.
Buyers prefer to allocate less to assets that must be amortized or depreciated over relatively long periods (such as buildings and intangibles) and assets that must be permanently capitalized for tax purposes (such as land).
On the flip side, sellers want to allocate more of the purchase price to assets that will generate low-taxed long-term capital gains, such as intangibles, buildings and land. Tax-smart negotiations can result in allocations that satisfy both sides.
Buying or selling a business may be the most important transaction of your lifetime, so it's critical to seek professional tax advice as you negotiate the deal. After the deal is done, it may be too late to get the best tax results. If you have any questions or would like further discussion on this topic, contact us at your earliest convenience.
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